Economists worry too much about the government’s deficit although they seem to not know about the private sector deficit.
Goldman Sachs’ chief economist Jan Hatzius came to know about the sectoral balances approach and called the difference between United States’ private expenditure and income in “The Un-Godley Private Sector Deficit”. He later included the sectoral balances approach in his forecasting models.
Here’s the sectoral balances for the United States using data from the Federal Reserve’s Z.1 Flow Of Funds Accounts Of The United States:
GDP appears in Table F.6 and sectoral balances in Table F.8 – as “Net Lending(+)/Net Borrowing(-)”. The above is using quarterly seasonally adjusted data. Easy work. Excel data is available at the Federal Reserve’s page here
It can be verified that
Private Sector Balance = Government Deficit + Current Balance of Payments
The red line is the private sector balance and is the difference between the private sector income and expenditure. When positive, the private sector is in surplus and when negative, it is in deficit.
For most of history having been positive (and back to being positive now), the private sector balance made a dramatic shift in the mid-1990s reaching as low as as -5.8% in Q1 2000 (and hence “private sector deficit”). This implied that before the recession, growth in the United States was driven by higher private expenditure relative to income. The flip side of this growth was that due to the Un-Godley private sector deficits, the budget went into a surplus while private indebtedness continued to rise.
This was enough to cause a recession in the early 2000s and the US government had to provide a massive fiscal stimulus to prevent a severe recession. The Federal Reserve also provided stimulus by keeping interest rates low but the private sector went into a deficit again – rushing to participate in a boom. The result of all this was the increase in the current account deficit of the United States to about 6.43% of GDP at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale and cracks started to appear in the foundations of growth – as warned by a series of articles from the Levy Institute.
This appears a bit like Scenario 4 in a Levy Institute paper Debt And Lending – A Cri De Coeur by Wynne Godley and Gennaro Zezza from April 2006 – the “gloomiest variant” according to the authors – where a drastic fall in private expenditure relative to income induces a recession in the United States, reducing the current account balance dramatically and increasing the budget deficit (to eventually enough to become the central debate in US politics).
And it turned out that the private sector deficit quickly went into a surplus – faster than the scenario presented above because the private sector could not handle the rise in indebtedness. The fall in private expenditure relative to income also meant – as mentioned above – that the United States went into a deep recession – from which it is still recovering.
My previous post Saving Net Of Investment was written to disprove claims made by Neochartalists such as
Without a government deficit, there would be no private saving.
I don’t publish comments and respond privately and I had two comments from someone whom I couldn’t track back. So here’s a reply.
Hi Ramanan,
Great work here. Thanks.
Two questions.
1. Can you explain what this means precisely? Does it just mean the household sector was borrowing more when the surplus was run? Where did their savings come from exactly?
2. It’s perfectly possible for the private sector to save if the budget is balanced and the foreign sector runs a trade surplus, right?
Thanks!
Just to add one more question. How can the private sector save without a government budget deficit? Is this accurate?
1. Household’s must be paid in the form of an asset, the firm’s liability?
2. The country must run a current account surplus (balanced budget deficit)?
My whole point is that saving and “net saving” are drastically different. A sector or the whole private sector can have positive saving and a net borrowing (flow) simultaneously.
Can you explain what this means precisely? Does it just mean the household sector was borrowing more when the surplus was run? Where did their savings come from exactly?
Yes the household sector was in deficit in 1999 onward as can be seen from line 48 of the F.8 data I attach in my blog.
It’s perfectly possible for the private sector to save if the budget is balanced and the foreign sector runs a trade surplus, right?
Yes of course. It is also possible for the private sector to having positive saving if the budget is balanced and the foreign sector runs a surplus or deficit. Of course, we are talking of the possibility (not sustainability) but data shows this was true in reality as well.
How can the private sector save without a government budget deficit? Is this accurate?
1. Household’s must be paid in the form of an asset, the firm’s liability? 2. The country must run a current account surplus (balanced budget deficit)?
Yes the private sector can save without a budget deficit – which is what the data I linked shows 🙂
It’s not even necessary to run a trade/current account surplus for this. And that’s what the F.8 data for 1998-2000 shows.
This is because saving takes the form of both accumulation of real assets and financial assets.
The whole point is that saving is just defined as disposable income minus consumption expenditure. Expenditure for house purchase is not subtracted, for example.
But this is mixing up saving for saving net of investment.
Now, “saving net of investment” is sometimes called “net private saving”, although the originators such as Wynne Godley always specified this.
I guess the the root of the confusion on the part of those who have inherited this terminology from the originators is to treat the “net” in net private saving as a result of netting due to aggregation alone, and take the sectoral balances identity – whereas the “net” is crucially net of investment.
In a recent post Income And Expenditure Flows And Financing Flows, I went into concepts such as saving, saving net of investment, net acquisition of financial assets, net incurrence of liabilities, and “net lending(+)/net borrowing(-)” and you may read the example there on the calculation of these flows. I also went into clarifying this by an example but let’s just check this for the case of the United States with actual data from the Federal Reserve Z.1 Statistical Release Flow Of Funds Accounts Of The United States from the historical data from 1995-2004 available here. In particular the table F.8.
In the above, the data highlighted in blue is the current account balance. With the whole nation’s expenditure higher than income, it’s net lending was negative – i.e., it was a net borrower (from the rest of the world).
Also, the government budget was in surplus in the years (line 49 highlighted in red).
Also, here’s the part which has the potential to create more confusions. The Net Saving defined by the flow of funds accountants is Saving net of Consumption of Fixed Capital (i.e., depreciation). So this can be checked from items highlighted in yellow.
So, the private sector had a positive saving even though the budget was in surplus and the current balance of payments in deficit!
Of course, this meant that the private sector financial balance is negative and this you can see in line 43 highlighted in Red.
Spain as a nation owes the rest of the world around €995bn according to the Banco de España International Investment Position data which is very high when compared to the 2011 GDP of €1,073bn. (And according to today’s release, real GDP fell 0.3% q/q in Q4 2011.)
Although, credit conditions in domestic and international money markets and capital markets in the Euro Area seemed to have eased in January, it seems Spanish banks are still not in the best shape. According to a Banco de España release, TARGET2 liabilities increased to around €176bn in January from around €151bn in December. Also, as a result banks in Spain have made heavy use of the LTRO facility as per the screenshot below:
(click to enlarge)
So capital flight out of Spain continues. Of course, this process can go on for longer than one could ever imagine earlier (because of the accommodative policy of the ECB and the laws governing the operations of the Eurosystem) but it is a good indicator of stress in balance-of-payments financing for Spain and the lack of fiscal space.
A commenter on my post on Net Worth asked me if I could do an example.
Here it goes.
First I do it as done by national accountants as per 2008 SNA – the System of National Accounts and then by the method used by the Federal Reserve’s Z.1 Flow of Funds Accounts.
The example is from a Levy Institute working paper by Antonio C. Macedo e Silva and Claudio Dos Santos with tables created more neatly here.
Let us assume that a single firm starts with the following balance sheet.
Opening Stocks: 2011
$
Assets
900
Nonfinancial Assets Financial Assets
600 300
Liabilities and Net Worth
900
Securities Other Than Shares Loans Shares and Other Equity Net Worth
150 250 450 50
In the above Net Worth is defined as we did earlier by treating equities as liabilities of a corporation. As we saw in the table Transactions Flow Matrix in the post Sources And Uses Of Funds, firms finance investment by retained earnings, and incurring liabilities. It was a simplified matrix of course and firms may also by sale of assets they hold.
An important point in the analysis is that this is for a single firm not the consolidated corporate sector as I am going to assume it will purchase physical capital from another firm for which it is a part of current receipts and hence a source of funds for the latter. That is, in the Transactions Flow Matrix, “I” appears both in the current and capital account of the consolidated production firms sector but here we are interested in a single firm.
Let us assume in an accounting period the firm retains $90 of earnings and finances a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans, issuing $40 of equities in the markets and selling existing financial assets worth $70.
The closing balance sheet will be as follows:
Closing Stocks: 2011
$
Assets
1,230
Nonfinancial Assets Financial Assets
1000 230
Liabilities and Net Worth
1,230
Securities Other Than Shares Loans Shares and Other Equity Net Worth
200 400 490 140
We assume away capital gains i.e., asset prices haven’t changed for the sake of clarity. As you see, net worth has increased from $50 to $140 and this is due to the firm’s saving – undistributed profits of $90. In general, asset prices change all the time and there will be holding gains and/or losses in both assets and liabilities.
What about flows such as the financial balance?
Here Saving = +$90
Net Incurrence of Liabilities = (+$50) + (+$150) + (+$40) = +$240
Net Acquisition (or Accumulation) of Financial Assets = (-$70)
because of the sale of assets and hence
Net Lending by the firm = (-$70) – (+$240) = (-$310)
(This is also called NAFA in old terminology, instead of splitting Net Lending into Net Accumulation of Financial Assets and Net Incurrence of Liabilities.)
To check: this is equal to Saving Minus Investment which is +$90 – $400 which is equal to -$310 – the “financial balance” of the firm.
So even though we have a negative financial balance, the firm’s net worth has increased. However note that by doing so, the firm’s financial assets/liabilities ratio has reduced – increasing its fragility somewhat.
As mentioned earlier, the purchase of physical capital was from another firm and we have not consolidated the corporate sector and hence the above balance sheets are for a single firm only.
Alternative Approach
The Federal Reserve will do this differently because equities issued by corporations are treated as if they are not liabilities in its Z.1 Flow of Funds Accounts of the United States and accordingly the example will need to be modified to look like this:
Opening Stocks: 2011
$
Assets
900
Nonfinancial Assets Financial Assets
600 300
Liabilities and Net Worth
900
Securities Other Than Shares Loans Net Worth Memo: Shares and Other Equity
150 250 500 450
I have added Equities in “Memo” as per the Federal Reserve’s practice and the Net Worth at the beginning of the period is $500. With the same set of transactions – a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans, issuing $40 of equities in the markets and selling existing financial assets worth $70, while retaining earnings of $90 in the period, the closing stocks will be as below:
Closing Stocks: 2011
$
Assets
1,230
Nonfinancial Assets Financial Assets
1000 230
Liabilities and Net Worth
1,230
Securities Other Than Shares Loans Net Worth Memo: Shares and Other Equity
200 400 630 490
Here Net Worth increased by $130 from $500 to $630 because of retained earnings of $90 and issuance of equities of $40 in the period.
The second approach is more like an “own funds” approach.
Readers of this blog may be aware of my fanhood for Wynne Godley and the title of this post is from a paper by him from 2004, although it was US-centric. This post is on imbalances in the Euro Area.
Wynne had not only always foreseen crises, but also knew about the muddle in the public debate and in academia both before and after the crises and the policy space available to resolve the crisis. Here’s from the short paper:
The public discussion is fractured. There are vacuous suggestions coming from sections of Wall Street that Goldilocks has been reincarnated and everything is fine. There are right-wing voices calling unconditionally for cuts in the budget deficit. The Bush administration seems complacent and, thank goodness, is not being convinced about cutting the federal budget deficit any time soon. Many are concerned about the current account deficit. Some of them fear a big and “disorderly” devaluation of the dollar while others think the dollar isn’t falling enough. No one has a clear idea about what can actually be done, by whom, and when. I have no sense that anyone who pontificates on these matters (outside the Levy Institute!) does so with the benefit of a comprehensive stock-flow model—the indispensable basis for competent strategic thinking.
In his 1983 book Macroeconomics, with Francis Cripps, he wrote:
… Our objective is most emphatically a practical one. To put it crudely, economics has got into an infernal muddle. This would be deplorable enough if the disorder was simply an academic matter. Unfortunately the confusion extends into the formation of economic policy itself. It has become pretty obvious that the governments of many countries, whatever their moral or political priorities, have no valid scientific rationale for their policies. Despite emphatic rhetoric they do not know what the consequences of their actions are going to be. Moreover, in a highly interdependent world system this confusion extends to the dealings of governments with one another who now have no rational basis for negotiation.
Eurostat, the statistical office of the European Union published for the first time today the indicators of the “Macroeconomic Imbalances Procedure Scoreboard”.
The Headline Indicators Statistical Information release provides detailed data (since 1995) for current account imbalances, the net international investment position, share of world exports, private credit flow (net incurrence of liabilities discussed in the previous post), private debt and the general government debt for the EU27 countries not just EA17. People a bit familiar about Post Keynesian Stock-flow coherent macro models will be aware of the connection between these.
The flow accounting identity
NL = PSBR + BP
where NL is the Net Lending of the private sector to the rest of the world, PSBR is the Public Sector Borrowing Requirement, equal to the government’s deficit and BP is the current balance of payments (or simply the current account balance) adds to stocks of assets and liabilities via the short-hand equation (also mentioned in the previous post)
and hence the connection between the stocks and flows mentioned by Eurostat. The report also provides data for Real Effective Exchange Rates, Normal Unit Labour Costs, evolution of House Prices (which rise faster in booms and do the opposite in busts) relative to prices of final consumption expenditure of households.
The Euro Area was formed with the “intuition” that by having a single currency, among other advantages – the nations would not have balance-of-payments problems at all.
Wynne Godley saw this muddle as early as 1991:
(click to expand in a new tab)
Writing for The Observer where he said:
… But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports.
Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure.
and that:
… If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.
The Eurostat is a statistical organization and its job is to report and maybe suggest some policies to the policy makers. It has rightly identified the imbalances which are looking for a policy. Unfortunately, these imbalances are typically brought to a balance (or at least attempted to) by deflating demand and hence reducing output and increasing unemployment. The recent treaty changes with a new “fiscal compact” shows what the policy makers are trying to do. But they do not realize its implications!
Here’s from a 1995 articleA Critical Imbalance in U.S. Trade written by Godley:
Refuting the “Saving is Too Low” Argument
It is sometimes held that, in the words of the Economist (May 27. 1995, p. 18), “America’s current account deficit is enormous because its citizens save so little and its government spends too much.” The basis for this proposition is the accounting identity that says that the private sector’s surplus of saving over investment is always equal to the government’s deficit plus (or minus) the current account surplus (or deficit). As this relationship invariably holds by the laws of logic, it can be said with certainty that if private saving were to increase given the budget deficit or if the budget deficit were to be reduced given private saving, the current account balance would be found to have improved by an exactly equal amount. But an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.
and also in The United States And Her Creditors: Can The Symbiosis Last? (link) from 2005:
A well-known accounting identity says that the current account balance is equal, by definition, to the gap between national saving and investment. (The current account balance is exports minus imports, plus net flows of certain types of cross-border income.) All too often, the conclusion is drawn that a current account deficit can be cured by raising national saving—and therefore that the government should cut its budget deficit. This conclusion is illegitimate, because any improvement in the current account balance would only come about if the fiscal restriction caused a recession. But in any case, the balance between saving and investment in the economy as a whole is not a satisfactory operational concept because it aggregates two sectors (government and private) that are separately motivated and behave in entirely different ways.
The European Commission has taken the report and produced another titled “Alert Mechanism Report” which has this table called “MIP Scoreboard” which highlights the imbalances in grey:
(click to expand in a new tab)
and makes observations on many individual nations – e.g., for Spain:
Spain: the economy is currently going through an adjustment period, following the build-up of large external and internal imbalances during the extended housing and credit boom in the years prior to the crisis. The current account has shown significant deficits, which have started to decrease recently in the context of the severe economic slowdown and on the back of an improving export performance, but remain above the indicative threshold. Since 2008 losses in price and cost competitiveness have partially reversed. While the adjustment of imbalances is on-going, the absorption of the large stocks of internal and external debt and the reallocation of the resources freed from the construction sector will take time to restore more balanced conditions. The contraction in employment linked to the downsizing of the construction sector and the economic recession has been aggravated by a sluggish adjustment of wages, fuelling rising unemployment.
The above is reminiscent of the Monetarist experiments of the 70s and the 80s where wages are squeezed by deflating demand (resulting in reducing employment instead of increasing it). No suggestion is made on how wages are to be negotiated. While I do not yet the best way to say the following, here it is: while wages are cost to firms, they are incomes to households and this strategy puts higher pressure on the fall in demand and creates a more recessionary scenario.
The Euro Area had no central government which is responsible for demand management in the broadest sense and individual nations having forgotten Keynesian principles, had haphazard policies from the start. In some nations, governments had a more relaxed fiscal stance but it was not seen in their budget balances because the domestic private sectors were happily involved in having its expenditure higher than income – adding to stronger growth and hence higher tax revenues. Thus the budget balance was seen under control. In others, this may have been the result of the private sector itself contributing to most of the increase in domestic demand by high net borrowing. The high growth in private sector incomes also led to deterioration in external balances of the weaker nations and the whole process was allowed to go due to irresponsible behaviour of the financial sector which was underpricing risk. Everyone was acting as if there was no balance-of-payments constraint (sectoral imbalances in general) which will hit hard someday.
When the crisis hit, governments realized that they had given up the ultimate protection (and simultaneously the lenders to governments) – making a draft at their home central bank.
Let me offer an intuition on sectoral balances in general and not just for the Euro Area. While it is true that a “good” sectoral balance is one in which all the “three financial balances” are near zero, it is important that policy be designed (and bargained at an international level) so that these balances are brought to their preferred paths of staying near zero in the medium term without affecting the aim of full employment.
So imagine a closed economy. Most economists would suggest that – under certain conditions – the government should design policy to aim to reach a budget surplus (or a primary surplus) but this comes at the cost of lower demand and higher employment and hence a poor strategy. A higher fiscal stance – as opposed to targeting a balanced budget – will automatically lead to primary surpluses in the medium term because of the increase in demand and national income leading to increases in the government’s tax receipts. In open economies this gets complicated. Under the current arrangement a unilateral fiscal expansion by a nation such as Spain is ruled out because this will bring about a return to high current account deficits because of a faster rise in domestic demand than domestic output putting the nation on a different unsustainable path.
Now this may sound like TINA – but it is not if one thinks of alternative strategies which are aimed at bring the three financial balances from getting out of hand but with a coordinated fiscal reflation. However, this is difficult without there being institutional means of achieving the desired outcome and hence there is an urgent need for a more integrated Europe with higher spending and taxing powers for the European Parliament (unlike the 2% budget rule of Charles Goodhart) which will be induced in substantial fiscal transfers. Competitiveness also needs to be addressed but the powers of the government go beyond fiscal policy alone and policies need to be designed in a more integrated Europe which reduce transfer addiction such as a common wages policy as suggested by George Irvin and Alex Izurieta in their article Fundamental Flaws In The European Project (August 2011):
Policy action is necessary if these trade imbalances are gradually to disappear. Crucially, labour productivity must increase faster in the deficit countries than in the surplus countries, an aim difficult to achieve unless proactive fiscal policy and infrastructure investment trigger a modernising wave of “crowding in” private investment. This means that Europe must redistribute investment resources from rich to poor regions. In addition, if higher labour productivity growth is to be achieved in the periphery, a “common wages policy” (not to be confused with a common wage) must be adopted which better aligns wage and productivity growth and sustains aggregate demand. This will not be achieved with wage disparities exercising a deflationary impact on the union. In the absence of national exchange rate realignment, adjustment must take place through a regional wage bargaining process.
Update: The European Commission background paper “Scoreboard For The Surveillance Of Macroeconomic Imbalances” is available at here.
In the previous two posts, I went into a description of the transactions flow matrix and the balance sheet matrix as tools for an analytic study of a dynamical study of an economy.
During an accounting period, sectors in an economy are making all kinds of transactions. These can be divided into two kinds:
Income and Expenditure Flows
Financing Flows
Let’s have the transactions flow matrix as ready reference for the discussion below.
(Click for a nicer view in a new tab)
The matrix can easily be split into two – on top we have rows such as consumption, government expenditure and so on and in the bottom, we have items which have a “Δ” such as “Δ Loans” or “change in loans”. We shall call the former income and expenditure flows and the latter financing flows.
To get a better grip on the concept, let us describe household behaviour in an economy. Households receive wages (+WB) and dividends from production firms (called “firms” in the table) and banks (+FD_{f} and +FD_{b}) respectively) on their holdings of stock market equities. They also receive interest income from their bank deposits and government bills. These are sources of households’ income. While receiving income, they are paying taxes and consuming a part of their income (and wealth). They may also make other expenditure such as buying a house or a car. We call these income and expenditure flows.
Due to these decisions, they are either left with a surplus of funds or a deficit. Since we have clubbed all households into one sector, it is possible that some households are left with a surplus of funds and others are in deficit. Those who are in surplus, will allocate their funds into deposits, government bills and equities of production firms and banks. Those who are in deficit, will need funds and finance this by borrowing from the banking system. In addition, they may finance it by selling their existing holding of deposits, bills and equities. The rows with a “Δ” in the bottom part of transactions flow matrix capture these transactions. These flows will be called financing flows.
How do banks provide credit to households? Remember “loans make deposits”. See this thread Horizontalism for more on this.
This can be seen easily with the help of the transactions flow matrix!
The two tables are some modified version of tables from the book Monetary Economics by Wynne Godley and Marc Lavoie.
It is useful to define the flows NAFA, NIL and NL – Net Accumulation of Financial Assets, Net Incurrence of Liabilities and Net Lending, respectively.
If households’ income is higher than expenditure, they are net lenders to the rest of the world. The difference between income and expenditure is called Net Lending. If it is the other way around, they are net borrowers. We can use net borrowing or simply say that net lending is negative. Now, it’s possible and typically the case that if households are acquiring financial assets and incurring liabilities. So if their net lending is $10, it is possible they acquire financial assets worth $15 and borrow $5.
So the the identity relating the three flows is:
NL = NAFA – NIL
I have an example on this toward the end of this post.
I have kept the phrase “net” loosely defined, because it can be used in two senses. Also, some authors use NAFA when they actually mean NL – because previous system of accounts used this terminology as clarified by Claudio Dos Santos. I prefer old NAFA over NL, because it is suggestive of a dynamic, though the example at the end uses the 2008 SNA terminology.
While households acquire financial assets and incur liabilities, their balance sheets are changing. At the same time, they also see holding gains or losses in their portfolio of assets. What was still missing was a full integration matrix but that will be a topic for a post later. Since, it is important however, let me write a brief mnemonic:
where revaluations denotes holding gains or losses.
This is needed for all assets and liabilities and for all sectors and hence we need a full matrix.
We will discuss more on the behaviour of banks (and the financial system) and production firms some other time but let us briefly look at the government’s finances.
As we saw in the post Sources And Uses Of Funds, government’s expenditure is use of funds and the sources for funds is taxes, the central bank’s profits, and issue of bills (and bonds). Unlike households, however, the government is in a supreme position in the process of “money creation”. Except with notable exceptions such as in the Euro Area, the government has the power to make a draft at the central bank under extreme emergency, though ordinarily it is restricted. Wynne Godley and Francis Cripps described it as follows in their 1983 book Macroeconomics:
Our closed economy has a ‘central bank’ with two principle functions – to manage the government’s debt and to administer monetary policy. [Footnote: The central bank has to fund the government’s operations but this in itself presents no problems. Government cheques are universally accepted. When deposited with commercial banks the cheque become ‘reserve assets’ in the first instance; banks may immediately get rid of excess reserve assets by buying bonds.]. The only instrument of monetary policy available to the central bank in our simple system is the buying and selling of government bonds in the bond market. These operations are called open market operations. We assume that the central bank does not have the right to directly intervene directly in the affairs of commercial banks (e.g., to prescribe interest rates or quantitative lending limits) or to change the 10% minimum reserve requirement. But the central bank is in a very strong position in the bond market since it can sell or buy back bonds virtually without limit. This gives it the power, if it chooses, to fix bond prices and yields unilaterally at any level [Footnote: But speculation based on expectations of future yields may oblige the central bank to deal on a very large scale to achieve this objective.] and thereby (as we shall soon see) determine the general level of interest rates in the commercial banking system.
Given such powers, we can assume in many descriptions that the government’s expenditure and the tax rate is exogenous. However, many times, there are many constraints such as price and wage rises, high capacity utilization and low production capacity and also constraints brought about from the external sector due to which fiscal policy has to give in and become endogenous.
While I haven’t introduced open economy macroeconomics in this blog in a stock-flow coherent framework, we can make some general observations:
For a closed economy as a whole, income = expenditure. While it is true for the whole economy (worth stressing again: closed), it is not true for individual sectors. The household sector, for example, typically has its income higher than expenditure. In the last 15-20 years, even this has not been the case. If one sector has it’s income higher than expenditure, some sectors in the rest of the world will have its income lower than its expenditure. Many times, the government has its income lower than expenditure and we see misleading public debates on why the government should aim to achieve a balanced budget. When a sector has its income lesser than expenditure, it’s net lending is negative and hence is a net borrower from the rest of the world. It can finance this by borrowing or sale of assets. A region or a whole nation can have its expenditure higher than income and this is financed by borrowing from the rest of the world. A negative flow of net lending implies a net incurrence of liabilities – thus adding to the stock of net indebtedness which can run into an unsustainable territory. Stock-flow coherent Keynesian models have the power to go beyond short-run Keynesian analysis and study sustainable and unsustainable processes.
… it is important to have in mind that it is possible to get three kinds of trajectories with SFC models:
trajectories toward a sustainable steady state;
trajectories toward a steady state over certain limits;
explosive trajectories.
The analysis of SFC models’ dynamic trajectories and steady states is useful, first because it makes clear to the analyst whether the regime described in the model is sustainable or whether it leads to some kind of rupture—either because the trajectory is explosive or because it leads to politically unacceptable configurations. In these cases, as Keynes would say in the Tract, the analyst can conclude that something will have to change and even get clues about (i) what will probably change (since the sensitivity of the system dynamics to changes in different behavioural parameters is not the same); and (ii) when this change will occur (since the system may converge or diverge more or less rapidly).
Example
Note that Net Lending is different from “saving”. Say, a household earns $100 in a year (including interest payments and dividends), pays taxes of $20 and consumes $75 and takes a loan of to finance a house purchase near the end of the year whose price is $500. Assume that the Loan-To-Value (LTV) of the loan is 90% – which means he gets a loan of $450 and has to pay the remaining $50 from his pocket to buy the house. (i.e., he is financing the house mainly by borrowing and partly by sale of assets). How does the bank lending – simply by expanding it’s balance sheet (“loans make deposits”). Ignoring, interest and principal payments (which we assume to fall in the next accounting period),
His saving is +$100 – $20 – $75 = +$5.
His Investment is +$500.
His Net Incurrence of Liabilities is +$450.
His Net Accumulation of Financial Assets is +$5 – $50 = – $45.
His Net Lending is = -$45 – (+$450) = -$495 which is Saving net of Investment ($5 minus $500).
This means even though the person has “saved” $5, he has incurred an additional liability of $450 and due to sale of assets worth $45, he is a net borrower of $495 from other sectors (i.e., his net lending is -$495).
Assume he started with a net worth of $200.
Opening Stocks: 2010
$
Assets
200
Nonfinancial Assets Deposits Equities
0 30 170
Liabilities and Net Worth
200
Loans Net Worth
0 200
Now as per our description above, the person has a saving of $5 and he purchases a house worth $500 by taking a loan of $450 and selling assets worth $50. We saw that the person’s Net Accumulation of financial assets is minus $45. How does he allocate this? (Or unallocate $45)? We assume a withdrawal of $10 of deposits and equities worth $35. At the same time, during the period, assume he had a holding gain of $20 in his equities due to a rise in stock markets.
Hence his deposits reduce by $10 from $30 to $20. His holding of equities decreases by $15 (-$35 + $20 = -$15)
How does his end of period balance sheet look like? (We assume as mentioned before that the purchase of the house occurred near the end of the accounting period, so that principal and interest payments complications appear in the next quarter.)
Closing Stocks: 2010
$
Assets
675
Nonfinancial Assets Deposits Equities
500 20 155
Liabilities and Net Worth
675
Loans Net Worth
450 225
Just to check: Saving and capital gains added $5 and $20 to his net worth and hence his net worth increased to $225 from $200.
Of course, from the analysis which was mainly to establish the connections between stocks and flows seems insufficient to address what can go wrong if anything can go wrong. In the above example, the household’s net worth gained even though he was incurring a huge liability. What role does fiscal policy have? The above is not sufficient to answer this. Hence a more behavioural analysis for the whole economy is needed which is what stock-flow consistent modeling is about.
One immediate answer that may satisfy the reader now is that the households’ financial assets versus liabilities has somewhat deteriorated and hence increased his financial fragility. By running a deficit of $495 i.e., 495% of his income, the person and his lender has contributed to risk. Of course, this is just one time for the person – he may be highly creditworthy and his deficit spending is an injection of demand which is good for the whole economy. After all, economies run on credit. While this person is a huge deficit spender, there are other households who are in surplus and this can cancel out. In the last 15 years or so, however (before the financial crisis hit), households (as a sector) in many advanced economies ran deficits of the order of a few percentage of GDP. If the whole household sector continues to be a net borrower for many periods, then this process can turn unsustainable as the financial crisis in the US proved.
Now to the title of the post. Flows such as consumption, taxes, investment are income/expenditure flows. Flows such as “Δ Loans”, “Δ Deposits”, “Δ Equities” are financing flows. Income/expenditure flows affect financing flows which then affect balance sheets, as we see in the example.
In my previous post Sources And Uses Of Funds, I used the term “net worth”, and the reader would have noted the the strange dissimilarity with business accounting.
It’s best first to verify that national accountants (with the exception of the Federal Reserve’s Z.1 flow of funds accounts of the United States) do it the way described in the previous post.
The UK Blue Book 2011 has the following description of Non-financial corporations’ balance sheet at the end of 2010:
Assets
Nonfinancial Assets Currency and Deposits Securities Other Than Shares Loans Shares and Other Equity Other Accounts Receivable
Liabilities and Net Worth
Currency and Deposits Securities Other Than Shares Loans Shares and Other Equity Other Accounts Payable Net Worth
£, billion
4,029.2
1,781.8 687.8 85.3 448.5 876.8 135.9
4,029.2
– 390.9 1,245.1 2,201.4 163.9 28.0
The relevant tables are below:
So “Shares and Other Equity” is treated as a liability of the corporation even though dividends are not compulsory. In a sense, equities are treated as being equivalent to debt securities. How does one calculate this? Assuming the relevant information is available, one simply needs to calculate the market value of equities issued by corporations.
The tendency to treat equities issued by corporations as not liabilities is misleading. This is all the more important if foreigners hold a large amount of equities and this may underestimate the indebtedness to foreigners. Indeed statistical agencies of many nations release data for the loosely defined term “external debt” and do not count equities held by foreigners in this. This “intuition” can easily be dismissed – foreigners can liquidate equities.
For comparison, below is the similar Z.1 statistic of Nonfarm Nonfinancial Corporate Businesses of the United States
The Federal Reserve by excluding the market value of equities issued in liabilities, exaggerates the net worth of corporations.
Business accounts commonly (but not invariably) record costs on an historic basis, partly to ensure that they are completely objective. Historic cost accounting requires goods or assets used in production to be valued by the expenditures actually incurred to acquire those goods or assets, however far back in the past those expenditures took place. In the SNA, however, the concept of opportunity cost as defined in economics is employed. In other words, the cost of using, or using up, some existing asset or good in one particular process of production is measured by the amount of the benefits that could have been secured by using the asset or good in alternative ways. Opportunity cost is calculated with reference to the opportunities foregone at the time the asset or resource is used, as distinct from the costs incurred at some time in the past to acquire the asset. The best practical approximation to opportunity cost accounting is current cost accounting, whereby assets and goods used in production are valued at their actual or estimated current market prices at the time the production takes place. Current cost accounting is sometimes described as replacement cost accounting, although there may be no intention of actually replacing the asset in question after it has been used.
So current cost accounting or replacement cost accounting is used. We saw in the last post that financial assets and liabilities are to be valued at their market values. In addition, real estate will be evaluated at the market price. Capital goods are to be valued at their replacement cost. Inventories should be valued at the current cost of production, not at the price the producers expect to it to sell.
Moreover, according to the SNA:
Current cost accounting has ramifications that permeate the entire SNA. It affects all the accounts and balance sheets and their balancing items. A fundamental principle underlying the measurement of gross value added, and hence GDP, is that output and intermediate consumption must be valued at the prices current at the time the production takes place. This implies that goods withdrawn from inventories must be valued at the prices prevailing at the times the goods are withdrawn and not at the prices at which they entered inventories. This method of recording changes in inventories is not commonly used in business accounting, however, and may sometimes give very different results, especially when inventory levels fluctuate while prices are rising. Similarly, consumption of fixed capital in the SNA is calculated on the basis of the estimated opportunity costs of using the assets at the time they are used, as distinct from the prices at which the assets were acquired. Even when the fixed assets used up are not actually replaced, the amount of consumption of fixed capital charged as a cost of production should be sufficient to enable the assets to be replaced, if desired. When there is persistent inflation, the value of consumption of fixed capital is liable to be much greater than depreciation at historic costs, even if the same assumptions are made in the SNA and in business accounts about the service lives of the assets and their rates of wear and tear and obsolescence. To avoid confusion, the term “consumption of fixed capital” is used in the SNA to distinguish it from “depreciation” as typically measured in business accounts.
Back to Net Worth
The SNA has this description of net worth:
Net worth is the difference between the value of all financial and non-financial assets and all liabilities at a particular point in time. For this calculation, each asset and each liability is to be identified and valued separately. As the balancing item, net worth is calculated for institutional units and sectors and for the total economy.
For government, households and NPISHs [Non-profit institutions serving households], the value of net worth is clearly the worth of the unit to its owners. In the case of quasi-corporations, net worth is zero, because the value of the owners’ equity is assumed to be equal to its assets less its liabilities. For other corporations, the situation is less clear-cut.
In the SNA, net worth of corporations is calculated in exactly the same way as for other sectors, as the sum of all assets less the sum of all liabilities. In doing so, the value of shares and other equity, which are liabilities of corporations, are included in the value of liabilities. Shares are included at their market price on the balance sheet date. Thus, even though a corporation is wholly owned by its shareholders collectively, it is seen to have a net worth (which could be positive or negative) in addition to the value of the shareholders’ equity.
Update: Corrected the values in the table at the beginning of the post.
In a recent post, I went into what is called the Transactions Flow Matrix. This is used heavily in Stock-Flow Consistent Modeling of the whole economy. The underlying theme is “everything comes from somewhere and goes somewhere, and there are no black holes”.
I also mentioned about a Balance Sheet Matrix. What is it?
Sectors in an economy have assets and liabilities. Assets can be both financial as well as nonfinancial. Since nonfinancial assets are nobody’s liability, liabilities are financial. Very quickly, a balance sheet matrix is created by assigning a + sign to assets and a (-) sign to liabilities.
As per the System of National Accounts, all assets and liabilities are to be evaluated at market prices. According to 2008 SNA,
So a corporation or the government may have issued bonds at $100 but since the value fluctuates everyday and even during the day, it is possible that the bond price may reach $103. If it is the last day of the period for which the balance sheet is compiled, then the liability should be entered as $103, not $100.
We will have more to see in another post but let us just have a cursory look at an item called net worth. Since balance sheets should balance, we include this item in liabilities or rather call the right hand side of a balance sheet “Liabilities and Net Worth”. The term Net Worth has an intuitive appeal. If I have assets worth $100 and owe someone (say a bank) $10 and nothing more or less, my net worth is $90.
So let us quickly jump into the balance sheet matrix of a model economy.
In the previous post on the Transactions Flow Matrix, I had amalgamated the sectors Government and Central Bank into one, but now I have separated them so that there is higher clarity.
The reason I am writing this post is to stress the importance of signs. So in the above you will notice that households have a liability of L_{h} and hence appears with a negative sign. We shall see below however, that since loans are a source of funds, it will appear as a positive sign in the transactions flow matrix!
So households hold currency notes, deposits, bills and equities and these have counterpart in some other sector. And this should be the case because every financial asset is someone else’s liability. Also, from the matrix, the sum of net worths of all sectors (for a closed economy, at any rate) is equal to the value of the nonfinancial assets. This result isn’t surprising since financial assets cancel out with their counterpart liabilities.
We now jump to the transactions flow matrix – which I remade and added a lot of complications as compared to the previously related post The Transactions Flow Matrix
(Click to enlarge in a new tab)
These matrices are almost exactly similar to what appears in Wynne Godley and Marc Lavoie’s book Monetary Economics.
The difference between the two matrices is that the balance sheet matrix records assets and liabilities at the beginning or the end of a period, whereas the transactions flow matrix records transactions during an accounting period.
In the previous post I had briefly stressed the importance of signs but now we have the balance sheet matrix as well ready, let me stress this again using a few lines from G&L’s book on the transaction flow matrix (page 40):
The best way to take it in is by first running down each column to ascertain that it is a comprehensive account of the sources and uses of all flows to and from the sector and then reading across each row to find the counterpart of each transaction by one sector in that of another. Note that all sources of funds in a sectoral account take a plus sign, while the uses of these funds take a minus sign. Any transaction involving an incoming flow, the proceeds of a sale or the receipts of some monetary flow, thus takes a positive sign; a transaction involving an outgoing flow must take a negative sign. Uses of funds, outlays, can be either the purchase of consumption goods or the purchase (or acquisition) of a financial asset. The signs attached to the ‘flow of funds’ entries which appear below the horizontal bold line are strongly counter-intuitive since the acquisition of a financial asset that would add to the existing stock of asset, say, money, by the household sector, is described with a negative sign. But all is made clear so soon as one recalls that this acquisition of money balances constitutes an outgoing transaction flow, that is, a use of funds.
So the government expenditure G has a minus sign because it is a use of funds and its sources are taxes, net issuance of bills and central bank profits.
The sources of funds for the production sector (abbreviated “firms”) is retained earnings (or undistributed profits, called FU), loans from banks and the issuance of equities and also sales (the consumption by households), government purchase of goods and investment itself because producers create tangible capital for themselves as a whole.
Now compare signs in the two matrices – equities are a source of funds for firms and hence has a positive sign in the transactions flow matrix but equities are also liabilities and hence the stock of equities appears with a negative sign in the balance sheet matrix.
Similarly, borrowing via loans are a source of funds for households and hence the positive sign in Table 2 while in Table 1 it appears with a minus sign.
For banks, making loans is a use of funds and taking deposits a source of funds. Hence minus and plus respectively in Table 2.
Also, the equities and loans in Table 2 are flows whereas in Table 1 they are stocks. Hence in Table 2, we have “Δ Loans” or change in loans, whereas in Table 1 its simply “Loans”.
Once we have a beginning of period balance sheet matrix and the transactions flow matrix, how do we construct the end of the period balance sheet matrix? I will leave this question for another post because I will have to introduce capital/holding gains and something called a full integration matrix. Before that I will have another post on real numbers taken from statistical releases to get more a intuitive feel for the balance sheet matrix.
The three matrices (the transactions flow matrix, the balance sheet matrix and the full integration matrix) go into the heart of “how money is created”. For this to be seen in detail, I will have to go into “monetary circuits” using transaction flows and that is the topic of yet another post. If you really understand how loans make deposits, the two tables should set you into a dynamical view of the whole process – a description completely different than the chimerical money multiplier model.
